Subchapter S Corp Restrictions

By Dennis Masino

Most people decide to incorporate their small businesses for the protection it gives them from personal liability for most business debts and obligations. The protection offered by operating a business as a corporation comes at a price. Corporate income is subject to double taxation: once when the corporation pays income taxes, and the second time when the shareholders pay income taxes on dividends they receive. Corporations that meet the restrictions for Subchapter S status can avoid double taxation. Income and losses of a Subchapter S or, as it is more commonly called, an S corporation, are passed through the corporation to the shareholders to be reported on their personal income tax returns, and the shareholders pay individual income tax rates that are lower than corporate rates.

Effect of Subchapter S Election

If you want to incorporate a business, you do so by filing in the state in which the corporation will be located and complying with the corporation laws of that state. A corporation is referred to as a C corporation for federal income tax purposes when it is first set up. Unless it elects to be treated as a Subchapter S corporation, all income and losses will be reported on the corporation's federal income tax return. Taxes are paid at the applicable corporate income tax rates. If the election is made to file as a Subchapter S corporation, the income and losses are passed through the corporation to be distributed among the shareholders. The shareholders report the income and losses on their personal income tax returns and pay at individual income tax rates.

Corporation Restriction

An S corporation must be a domestic corporation, and not a corporation formed in another country. It can have no more than 100 shareholders, none of whom can be a partnership, corporation or nonresident alien. Certain financial institutions, insurances companies, and domestic international sales corporations cannot elect to be treated as S corporations.

Ready to incorporate your business? Get Started Now

Classes of Stock

An S corporation can have only one class of stock. A corporation with a second class of stock does not qualify as an S corporation. Distributions of income and losses cannot be allocated to different classifications of shareholders.

Reasonable Compensation

If you are a shareholder-employee of an S corporation, you must be reasonably compensated for the services you perform. If not, the Internal Revenue Service may treat distributions and other non-wage payments as wages. This is to prevent shareholders who work for the company from avoiding income taxes by attempting to treat taxable wages as nontaxable distributions.

Ready to incorporate your business? Get Started Now
Is a Corporation the Same as an LLC?
 

References

Related articles

Can You Fill Out a 2553 Before the Articles of Incorporation?

A business entity that wishes to become an S corporation must file Form 2553 with the IRS. However, before a business can submit this form, it must first qualify for S corporation status and must file articles of incorporation with the state to incorporate the business.

How Much Should I Pay Myself From My Corporation?

An owner's decision regarding how much salary to take from a business is generally a private management decision for closely held corporations — corporations where half of the shares are held by five or fewer shareholders — that are not publicly traded. However, the decision is affected by potential tax consequences.

LLC Explained

A limited liability company (LLC) is a type of company that exhibits characteristics of both partnerships and corporations. Like a corporation, an LLC has a legal existence separate from that of its owners, who are called "members." Like a partnership, though, it avoids the double taxation problem that frequently accompanies corporations. Limited liability, flexibility in tax treatment and simplicity of operation have made the LLC a popular choice for small business start-ups.

LLCs, Corporations, Patents, Attorney Help Incorporation

Related articles

S Corporation Compliance

Corporations that meet the qualifications to be an S corp can be taxed as a pass-through entity. This allows the ...

S Corp Vs. Corp

Incorporating a business creates a separate legal entity and protects shareholders with limited liability. However, a ...

Tax Consequences of Converting a C-Corp to an S-Corp

Corporations are business entities formed under state law that exist separately from their owners. An S corporation is ...

How to Incorporate: S Corp or LLC?

Among small business entities, the limited liability company, or LLC, and Subchapter S corporation, or S corp, are ...

Browse by category
Ready to Begin? GET STARTED